America's Great Depression (25 page)

The first big investment in acceptances came in 1922, coincid-ing with the FRB’s allowing the New York Reserve Bank to control acceptance policy. Federal Reserve holdings rose from $75

million in January to $272 million in December of that year.

Despite the fact that the Federal Reserve kept its buying rate on acceptances below its rediscount rate, Paul Warburg, America’s leading acceptance banker and one of the founders of the Federal Reserve System, demanded still lower buying rates on acceptances.35 Undersecretary of the Treasury Gilbert, on the other hand, was opposed to the specially privileged acceptance rates, but of all bankers’ acceptances were held by the Federal Reserve, and the same proportion held true in June, 1929. See Hardy,
Credit Policies,
p. 258.

34See Senate Banking and Currency Committee,
Hearings On Operation of
National and Federal Reserve Banking Systems
(Washington, D.C., 1931), Appendix, Part 6, p. 884.

35See Harris,
Twenty Years,
p. 324n.

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the Federal Reserve continued its policy of subsidy, directed largely by the New York Bank.36 It was, indeed, only in the first half of 1929 that the Federal Reserve partially abandoned its subsidizing, and at least pushed its buying rate on acceptances above the rediscount rate, thereby causing a sharp reduction in its acceptance holdings. In fact, the decline in acceptances was almost the sole factor in the decline of reserves in 1929 that brought the great inflation of the 1920s to its end.

Why did the Federal Reserve newly create and outrageously subsidize the acceptance market in this country? The only really plausible reason seems to center around the role played by Paul M.

Warburg, former German investment banker who came to America to become a partner of Kuhn, Loeb and Company, and be one of the founders of the Federal Reserve System. Warburg worked for years to bring the rather dubious blessings of central banking to the hitherto backward United States. After the war and during the 1920s, Warburg continued to be chairman of the highly influential Federal Advisory Council, a statutory group of bankers advising the Federal Reserve System. Warburg, it appears, was a principal beneficiary of the Federal Reserve’s pampering of the acceptance market. From its inception in 1920, Warburg was Chairman of the Board of the International Acceptance Bank of New York, the world’s largest acceptance bank. He also became a director of the important Westinghouse Acceptance Bank and of several other acceptance houses, and was the chief founder and Chairman of the Executive Committee of the American Acceptance Council, a trade association organized in 1919. Surely, Warburg’s leading role in the Federal Reserve System was not unconnected with his reaping the lion’s share of benefits from its acceptance policy. And certainly, there is hardly any other way adequately to explain the adoption of this curious program. Indeed, Warburg himself proclaimed the success of his influence in persuading the 36About half of the acceptances in the Federal Reserve System were held in the Federal Reserve Bank of New York; more important, almost all
the purchases
of acceptances were made by the New York Bank, and then distributed at definite proportions to the other Reserve Banks. See Clark,
Central Banking,
p. 168.

The Inflationary Factors

129

Federal Reserve to loosen eligibility rules for purchase of acceptances, and to establish subsidized rates at which the Federal Reserve bought all acceptances offered.37 And finally, Warburg was a very close friend of Benjamin Strong, powerful ruler of the New York Bank which engaged in the subsidy policy.38

The Federal government progressively widened the scope of the acceptance market from the very inception of the Federal Reserve Act. Before then, national banks had been prohibited from purchasing acceptances. After the Act, banks were permitted to buy foreign trade acceptances up to a limit of 50 percent of a bank’s capital and surplus. Subsequent amendments raised the limit to 100 percent of capital and surplus, and then 150 percent, and allowed other types of acceptances—“dollar exchange,” and domestic acceptances. Furthermore, English acceptance practice had been strictly limited to documentary exchange, representing definite movements of goods. The Federal Reserve Board at first tried to limit acceptance to such exchanges, but in 1923 it succumbed to the pressure of the New York Reserve Bank and permitted “finance bills” without documents. Wider powers were also granted to the New York and other Reserve Banks in 1921 and 1922 to purchase
purely foreign
acceptances, and their permissible maturity was raised from three to six months. In 1923, as part of the agricultural credit program, the Fed was permitted to rediscount agricultural-based acceptances up to six months.39 In 1927, 37See a presidential address by Warburg before the American Acceptance Council, January 19, 1923, in Paul M. Warburg,
The Federal Reserve System
(New York: Macmillan, 1930), vol. 2, p. 822. Of course, Warburg would have preferred an even larger subsidy. Even Warburg’s perceptive warning on the developing inflation in March 1929, was marred by his simultaneous deploring of our “inability to develop a country-wide bill market.”
Commercial and Financial Chronicle
(March 9, 1929): 1443–44; also see Harris,
Twenty Years,
p. 324.

38See Lester V. Chandler,
Benjamin Strong, Central Banker
(Washington, D.C.: Brookings Institution, 1958), p. 39 and
passim.
It was only on the insistence of Warburg and Henry Davison of J.P. Morgan and Company, that Strong had accepted this post.

39See H. Parker Willis, “The Banking Problem in the United States,” in Willis, et al.,
“
Report of an Inquiry into Contemporary Banking in the United States,” pp. 1, 31–37.

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America’s Great Depression

bills were made eligible even if drawn
after
the goods had been moved.40

With the rules relaxed, purely foreign acceptances, representing goods stored in or shipped between foreign points, rose from nothing to the leading role in Federal Reserve acceptance holdings during the crucial 1928–1929 period. Foreign acceptance purchases played a large part, especially in the latter half of 1929, in frustrating all attempts to check the boom. Previous credit restrictions had been on the way to ending the inflationary boom in 1928. But in August, the Federal Reserve deliberately reversed its tight money policy on the acceptance market, and the Board authorized the Federal Reserve Banks to buy heavily in order to accommodate credit needs.41 The reasons for this unfortunate reversal were largely general: the political pressure for easier credit in an election year, and the fear of repercussions on Europe of high interest rates in the United States, played the leading roles. But there was also a more specific cause connected with the foreign acceptance market.

In contrast to older types of acceptance, the purely foreign acceptances were bills representing stored goods
awaiting
sale, rather than goods in transit between specific buyers and sellers.42

The bulk was used to finance the storage of unsold goods in Central Europe, particularly Germany.43 How did this increase in the holding of German acceptances come about? As the result of a spec-tacular American boom in foreign loans, financed by new issues of foreign bonds. This boom flourished from 1924 on, reaching a peak in mid-1928. It was the direct reflection of American credit expansion, and particularly of the low interest rates generated by 40See A.S.J. Baster, “The International Acceptance Market,”
American
Economic Review
(June, 1937): 298.

41See Charles Cortez Abbott,
The New York Bond Market, 1920–1930

(Cambridge, Mass.: Harvard University Press, 1937), pp. 124ff.

42See Hardy,
Credit Policies,
pp. 256–57. Also
Hearings, Operation of Banking
Systems,
Appendix, Part C, pp. 852ff.

43Sterling bills were also purchased by the Fed to help Great Britain, e.g., $16

million in late 1929 and $10 million in the summer of 1927. See Hardy,
Credit
Policies,
pp. 100ff.

The Inflationary Factors

131

that expansion. As we shall see further below, this result was deliberately fostered by the Federal Reserve authorities. Germany was one of the leading borrowers on the American market during the boom. Germany was undoubtedly short of capital, bereft as she was by the war and then by her ruinous inflation, culminating in late 1923. However, the German bonds floated in the United States did not, as most people thought, rebuild German capital.

For these loans were largely extended to German local and state
governments
, and not to private German business. The loans made capital even
scarcer
in Germany, for the local governments were now able to compete even more strongly with private business for factors of production.44 To their great credit, many German authorities, and especially Dr. Hjalmar Schacht, head of the Reichsbank, understood the unsoundness of these loans, and they together with the American Reparations Agent, Mr. S. Parker Gilbert, urged the New York banking community to stop lending to German local governments.45 But American investment bankers, lured by the large commissions on foreign government loans, sent hundreds of agents abroad to urge prospective borrowers to float loans on the American market. They centered their attention on Germany.46

The tide of foreign lending turned sharply after mid-1928. Rising interest rates in the United States, combined with the steep 44The boom in loans to Germany began with the 1924 “Dawes loan,” part of the Dawes Plan reparations, with $110 million loaned to Germany by an investment banking syndicate headed by J.P. Morgan and Company.

45Schacht personally visited New York in late 1925 to press this course on the banks, and he, Gilbert, and German Treasury officials sent a cable to the New York banks in the same vein. The securities affiliate of the Chase National Bank did comply with these requests. See Anderson,
Economics and the Public Welfare,
pp. 150ff. See also Garet Garrett,
A Bubble That Broke the World
(Boston: Little, Brown, 1932), pp. 23–24, and Lionel Robbins,
The Great Depression
(New York: Macmillan, 1934), p. 64.

46“In late 1925, the agents of fourteen different American investment banking houses were in Germany soliciting loans from the German states and municipalities.” Anderson,
Economics and the Public Welfare,
p. 152. Also see Robert Sammons, “Capital Movements,” in Hal B. Lary and Associates,
The United States
in the World Economy
(Washington, D.C.: U.S. Government Printing Office, 1943), pp. 95–100; and Garrett,
A Bubble That Broke the World,
pp. 20, 24.

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America’s Great Depression

stock exchange boom, diverted funds from foreign bonds to domestic stocks. German economic difficulties aggravated the slump in foreign lending in late 1928 and 1929. In consequence, German banks, finding their clients unable to float new bonds in the United States, obtained loans in the form of acceptance credits from the New York Reserve Bank, to cover the cost of carrying unsold stocks of cotton, copper, flour, and other commodities in German warehouses.47 Those American banks that served as agents of foreign banks sold great quantities of foreign (largely German) acceptances to other American banks and to the FRS.48

This explains the rise in Reserve holdings of German acceptances.

Other acceptances flourishing in 1928 and 1929 represented domestic cotton and wheat awaiting export, and exchange bills providing dollars to South America. In early 1929, there was also a rash of acceptances based on the import of sugar from Cuba, in anticipation of a heavier American tariff on sugar.49

Not only did the Federal Reserve—in effect the New York Bank—subsidize the acceptance market, it also confined its subsidizing to a few large acceptance houses. It refused to buy any acceptances directly from business, insisting on buying them from acceptance dealers as intermediaries—thus deliberately subsidizing the dealers. Further, it only bought acceptances from the few dealers with a capital of one million dollars and over. Another special privilege was the Federal Reserve’s increasing purchase of acceptances under
repurchase
agreements. In this procedure, the New York Bank agreed to buy acceptances from a few large and recognized acceptance dealers who had the option to buy them back in 15 days at a currently fixed price. Repurchase agreements varied from one-tenth to almost two-thirds of acceptance holdings.50 All this tends to confirm our hypothesis of the Warburg role.

47See Clark,
Central Banking,
p. 333. As early as 1924, the FRB had suggested that American acceptance credits finance the export of cotton to Germany.

48See H. Parker Willis,
The Theory and Practice of Central Banking
(New York: Harper and Bros., 1936), pp. 210–12, 223.

49
Hearings, Operation of Banking Systems,
pp. 852ff.

50Clark,
Central Banking,
pp. 242–48, 376–78; Hardy,
Credit Policies,
p. 248.

The Inflationary Factors

133

In short, the Federal Reserve granted virtual call loans to the acceptance dealers, as well as unrestricted access at subsidized rates and accorded these privileges to dealers who were not, of course, members of the Federal Reserve System. In fact, as unincorporated private bankers, the dealers did not even make public reports. So curiously jealous was the New York Bank of the secrecy of its favorites that it arrogantly refused to give a Congressional investigating committee either a list of the acceptance dealers from whom it had bought bills, or a breakdown of foreign acceptances by countries. The officials of the New York Bank were
not
cited for contempt by the committee.51

U.S. GOVERNMENT SECURITIES

Member bank reserves increased during the 1920s largely in three great surges—one in 1922, one in 1924, and the third in the latter half of 1927. In each of these surges, Federal Reserve purchases of government securities played a leading role. “Open-market” purchases and sales of government securities only emerged as a crucial factor in Federal Reserve monetary control during the 1920s. The process began when the Federal Reserve tripled its stock of government securities from November, 1921, to June, 1922 (its holdings totaling $193 million at the end of October, and $603 million at the end of the following May). It did so not to make money easier and inflate the money supply, these relationships being little understood at the time, but simply in order to add to Federal Reserve earnings. The inflationary result of these purchases came as an unexpected consequence.52 It was a lesson that was appreciatively learned and used from then on.